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Where is The Price of Oil Headed?

October 15, 2012

The price of oil experienced high volatility in the past couple of weeks. But despite this high volatility the price of oil remained close to its starting point from the beginning of month. Will this high volatility in the oil market continue? Further, will oil prices resume their downward trend? During October, the price of oil fell by 0.4%; United States Oil (NYSEMKT: USO), by 0.4%. The tensions in the Middle East may have contributed to the high volatility in the oil market, but the stable OPEC oil production, the decline in the IEA projection for global demand in 2012, the rise in U.S oil production and refineries input, and the appreciation of the USD against leading currencies curbed the rally of the price of oil. Let’s further explore these issues and determine what is next for oil prices.

The high volatility of oil prices has also affected several oil producers including Chevron Corporation (NYSE: CVX) and Exxon Mobil Corporation (NYSE: XOM). During October, the linear correlation between Chevron and oil (daily percent changes) is 0.4, and between Exxon and oil it is 0.43. Thus, nearly 16% of Chevron’s volatility and 18% of Exxon Mobil’s volatility (under the assumptions of linearly of relation and normality of data) could be attributed to the shifts in the price of oil. The moderate fall in oil prices may have also pulled down these oil producers’ stocks. These energy companies are also strongly correlations with the S&P500 index (during October the linear correlations reached 0.56 and 0.46, respectively). Thus, the ongoing fall of the S&P500 may have also pulled down, to a certain extent, these energy companies stocks. Nonetheless if the price oil will continue to dwindle it could affect the valuation, assuming we use DCF, of Chevron and Exxon. So let’s see what has changed in the oil market:

Storage

Last week, the U.S. Petroleum and oil stockpiles decreased by 4.3 million barrels; it reached 1,792 million barrels. The current oil stockpiles are 22.9 million barrels above the levels were during the parallel week in 2011. The linear correlation between the changes in stockpiles and oil prices is mid-strong and negative, which mean that if oil stockpiles will further fall, it could suggest that oil prices are likely to rally.

Supply

From the Supply side, according the previous EIA report, the U.S oil production continues to rally, as the average production rose last week by 4.3% (week over week). Refinery inputs also rose by 0.7%. Based on these data, the U.S supply expanded last week, and might be among the factors to curb the rally of oil prices. This explanation seems reasonable, but the data don’t support this claim. The chart below shows the development of the four week average oil production and the weekly average price of oil between the years 2011 and 2012. The trend between the two data sets seems to coincide, but when examining the linear correlation between the two is roughly -0.015, which isn’t significant. Therefore, the weekly shifts in oil production aren’t enough to explain the movement of oil prices on weekly scale. Nonetheless, if the oil production will further rise it will help pull down the price of oil in the long run.

As for OPEC’s oil production there wasn’t any sharp changes during last month. According the recent OPEC report, the total oil production only slightly declined by 31,078 thousand bbl/d in September. All eyes continue to be on Iran as its oil production remains low: its oil production reached 2,723 thousand, which is still a relatively low oil production compared to pervious months. This might suggest that if the oil production will remain low, it could eventually affect the oil market. The ongoing tensions in the Middle East and the sanctions of Europe and U.S on Iran raise the chances of an escalation in the Middle East that could adversely affect Iran’s oil production.

Keep in mind that it doesn’t require a sharp drop in production for the price of oil to rise precipitately. The oil production of Libya, which was back before the civil war around 1,600 thousand bbl/d – nearly half of Iran’s production – caused the price of oil to jump by more than $20 per bbl within a matter of weeks. Thus, even a 50% drop in Iran’s production could cause a sharp in rise in oil prices. This raises the question, is there something to worry over?

The big question is whether the U.S will commence a full blown attack in Iran along with Israel. Since there is still time until the Presidential elections, this question won’t be answered until then. Further, the recent decision in the Israeli parliament to have elections at the end of January also pushes even further the debate over an attack at least after the Israeli elections. Therefore, I don’t think the oil market will be affected by the tensions in the Middle East. There could be additional speculations about the future steps of these three nations that could affect the oil price, but again I don’t think these speculations will mount to a fundamental change.

This leaves with the demand side and the fluctuations in the currencies that could have a substantial effect on the oil prices. In regards to the demand, the recent IEA report projects a decline in the growth in the demand for oil in 2012. This could loosen the oil market and thus lower the price of oil.

Therefore, I think that the price of oil will continue to fall in the weeks to follow; there might be additional high shifts in the price of oil as the tensions in the Middle East will remain high, but unless there will be some unexpected development that is related to the oil market, e.g. an escalation in the Middle East, another Hurricane in the Gulf of Mexico, etc. I still guess the price of oil will come down.